Moving the Conceptual Framework Forward: Accounting for Uncertainty Richard Barker Saïd Business School, Oxford University Stephen Penman Columbia Business School, Columbia University July 2017 As an Occasional Paper, this paper does not necessarily reflect the views of CEASA, nor of its sponsors. CEASA positions are expressed in White Papers. Center for Excellence in Accounting & Security Analysis Center for Excellence in Accounting & Security Analysis Columbia Business School established the Center for Excellence in Accounting and Security Analysis in 2003 under the direction of Professors Trevor Harris and Stephen Penman. The Center (“CEASA”) aims to be a leading voice for independent, practical solutions for financial reporting and security analysis, promoting financial reporting that reflects economic reality and encourages investment practices that communicate sound valuations. 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More information and access to current research is available on our website at http://www.gsb.columbia.edu/ceasa The Center is supported by our generous sponsors: General Electric, IBM and Morgan Stanley. We gratefully acknowledge the support of these organizations that recognize the need for this center. Center for Excellence in Accounting & Security Analysis Moving the Conceptual Framework Forward: Accounting for Uncertainty Abstract To meet the objectives of financial reporting in the IASB's Conceptual Framework, the 'balance-sheet approach' embraced by the Framework is necessary but not sufficient. Critical, but largely overlooked, is the role of uncertainty, which we argue defines the role of accrual accounting as a distinctive source of information for investors when investment outcomes are uncertain. This role is in some sense paradoxical: on the one hand, uncertainty undermines both the balance sheet (because uncertain assets are unrecognized) and the income statement (because mismatching is unavoidable). However, these inevitable accounting effects can be exploited to provide information about uncertainty, though not by a balance-sheet approach alone. Rather, criteria for balance sheet recognition and measurement, and for income statement presentation, are established by consideration of the impact of uncertainty on matching and mismatching in the income statement. This combination of balance-sheet and income-statement approaches enhances the communication of information to investors under conditions of uncertainty, thereby giving greater clarity and purpose in satisfying the objective of the Framework to provide information about "the amount, timing, and uncertainty of future cash flows". This paper has benefited from comments by Anwer Ahmed, Mary Barth, Sudipta Basu, Colin Clubb, Steve Cooper, Ilia Dichev, Trevor Harris, Tom Linsmeier, Anne McGeachin, Peter Pope, Shiva Rajgopal, Thomas Ryttersgaard, Katherine Schipper, Alan Teixeira, Geoff Whittington, conference participants at CAR and EAA, and seminar participants at Bristol, Copenhagen, Essex, Innsbruck, Manchester, Newcastle and Portsmouth. 1. Introduction The Conceptual Framework of the International Accounting Standards Board (Exposure Draft, IASB, 2015; hereafter ‘Framework’), assigns conceptual primacy to the definition of assets (liabilities), expressed in terms of rights (obligations) with respect to economic benefits (Storey and Storey, 1998; Dichev, 2008). The logic of this ‘balance sheet approach’ is that (net) income is determined as a by-product of the recognition and measurement of (net) assets in the balance sheet. Accordingly, while much of the Framework is concerned with the definition, recognition, and measurement of (net) assets, it offers remarkably little conceptual guidance with respect to the income statement. Particularly noteworthy is that, first, the Framework seemingly rejects the long-standing, ‘traditional’ income statement concept of the ‘matching’ of revenues with expenses (Zimmerman and Bloom, 2016) and, second, it offers no conceptual guidance on the income statement, and so is silent on (for example) the distinctions between income (expenses) and gains (losses), and between gross profit and net profit (Barker, 2010).1 This paper argues that this ‘marginalisation’ of the income statement arises because the concept of uncertainty is insufficiently developed in the Framework, with the effect that the inherent usefulness of the technology of accrual accounting is inadequately captured. Evidence of this conceptual oversight is that the Framework implicitly assumes that its ‘valuation-relevance’ and ‘stewardship’ objectives in the Framework can best be addressed by accrual accounting, yet it does not justify why this is the case. We argue that uncertainty is the key concept that would provide this justification. At present, the Framework’s discussion of uncertainty is mostly in the context of the challenges that it creates for the measurement of assets and liabilities (e.g. paras. 5.15-5.21) – in other words, it is balance-sheet oriented - yet this does not get to the heart of why the concept of uncertainty is so important for accounting. We argue that the balance-sheet approach can be extended to accommodate the implications of uncertainty for the informational-usefulness of the income statement, as well as the balance sheet, thereby explicitly acknowledging that the usefulness of accruals lies in the articulation between these two statements. We argue that our approach would: 1 The IASB stresses that the income statement is not overlooked (BC4.3). It is likely that, in practice, the IASB does think through income and expenses issues in making recognition and measurement decisions with respect to assets and liabilities. Yet such thinking is not formalised conceptually in the Framework with the same logical clarity that is applied to the deductive approach that starts with the formal definitions of assets and liabilities. 1 enhance the Framework’s conceptualisation of recognition, measurement, and presentation; strengthen the conceptual foundations of individual accounting standards; and define an accounting for income and expenses (including an income statement presentation) that would be guided by the matching concept in providing useful information to investors. To develop this argument, we accept the ‘top-down’, deductive approach embodied in the Framework, notwithstanding that in practice such as approach is inevitably partial, fluid and, to a degree, grounded in convention (Dopuch and Sunder, 1980; Macve, 1997, 2010 and 2015; Bromwich et al., 2010); in short, we take as given that the Framework forms part of the modus operandi of the IASB, and our conceptual analysis is conducted within that frame. We structure our argument as follows. In Section 2, we note that a striking feature of the Framework is its rejection of the matching concept, notwithstanding the central role that matching has traditionally played in accruals accounting. We then note, in Section 3, that the Framework actually has very little to say about accruals, and in particular about why the technology of accrual accounting is presumed to provide useful information to investors. In Section 4, we argue that the concept of uncertainty is critical in making sense of these observations from Sections 2 and 3. This is because conditions of uncertainty render both the balance sheet and the income statement ‘incomplete’, yet complementary, with respect to the IASB’s objective of providing decision-useful information to investors. In short, we argue that the challenge caused by uncertainty calls for the design of an accrual accounting system that adopts both a balance-sheet and an income-statement perspective, and that this demands consideration of the matching concept. Such a conclusion appears to stand in contrast with the Framework’s balance- sheet approach, which we explore in Section 5. In line with this approach, the Framework explicitly addresses uncertainty in the context of balance-sheet recognition and measurement only. We argue, however, that the Framework also implicitly incorporates uncertainty into its definition of (net) assets, and that this goes a considerable way towards meeting the informational needs of investors, especially in the case of revenue recognition. Given, however, that this incorporation of uncertainty is in effect ‘subconscious’ within the Framework, it is perhaps not surprising that its implications are not fully realised. In Section 6, we therefore propose a ‘conscious’ extension, which employs additional balance-sheet recognition criteria that take into consideration the articulating income statement. At heart, the approach can be viewed as 2 structuring and presenting information that the